Before discussing interest and dividends, it is important to discuss the concept of active, passive, and portfolio income. Because of past abuses involving tax shelters, Congress enacted legislation limiting the deduction of certain losses. The limits are referred to as the “passive loss limitations.” In establishing the limitations, the tax law classifies individual income into three categories: (1) active income (e.g., salaries, wages, and self-employment income), (2) passive income (e.g., income from limited partnership interests and real estate investments), and (3) portfolio income (e.g., dividends and interest).

Generally, passive losses cannot be used to offset either active or portfolio income. Also, tax credits derived from passive activities can only offset income taxes attributable to passive income. Unused passive losses and credits are carried over and may be used to offset future passive income or taxes attributable to such income, respectively. Generally, losses remaining when the taxpayer disposes of his or her entire interest in the passive activity may be used in full; however, the taxpayer can only use remaining credits to offset the income tax arising from any gain recognized when disposing the activity.